The Adaptive Markets Hypothesis: Market E ciency from an ...

The Adaptive Markets Hypothesis:

Market Efficiency from an

Evolutionary Perspective

Andrew W. Lo

August 15, 2004

Abstract

One of the most influential ideas in the past 30 years of the Journal of Portfolio Management is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution--competition, adaptation, and natural selection--to financial interactions. By extending Herbert Simon's notion of "satisficing" with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality--loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases--are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.

I thank Peter Bernstein, Frank Fabozzi, Stephanie Hogue, Dmitry Repin, and Svetlana Sussman for helpful comments and discussion. Research support from the MIT Laboratory for Financial Engineering is gratefully acknowledged.

Harris & Harris Group Professor, MIT Sloan School of Management and Chief Scientific Officer, AlphaSimplex Group, LLC. Please address all correspondence to: MIT Sloan School, 50 Memorial Drive, E52-432, Cambridge, MA 02142?1347. (617) 253?0920 (voice), (617) 258?5727 (fax), alo@mit.edu (email).

Introduction

The 30th anniversary of the Journal of Portfolio Management is a truly impressive milestone in the rich intellectual history of modern finance, firmly establishing the relevance of quantitative models and scientific inquiry for the practice of financial management. One of the most enduring ideas from this intellectual history is the Efficient Markets Hypothesis (EMH), a deceptively simple notion that has become a lightning rod in the storm of controversy between its disciples and the proponents of the emerging field of behavioral economics and finance. In its purest form, the EMH obviates the need for active portfolio management, calling into question the very motivation for the Journal of Portfolio Management! Therefore, it is only fitting that we revisit this groundbreaking idea after three very successful decades of this journal.

In this article, I review the current state of the controversy surrounding the EMH and propose a new perspective that reconciles the two opposing schools of thought in a natural and intellectually satisfying manner.1 The proposed reconciliation, which I call the "Adaptive Markets Hypothesis" (AMH)--is based on an evolutionary approach to economic interactions, as well as some recent research in the cognitive neurosciences that has been transforming and revitalizing the intersection of psychology and economics. Although some of these ideas have not yet been fully articulated within a rigorous quantitative framework, long-time students of the EMH and investment professionals will no doubt recognize immediately the possibilities generated by this new perspective. Only time will tell whether its potential will be fulfilled.

I begin with a brief review of the classical version of the EMH, and then summarize the most significant criticisms levelled against it by psychologists and behavioral economists. I argue that the sources of this controversy can be traced back to the very origins of modern neoclassical economics, and by considering the sociology and cultural history of modern finance, we can develop a better understanding of how we arrived at the current crossroads for the EMH. I then turn to the AMH, in which the dynamics of evolution--competition,

1Parts of this article include ideas and exposition from several previously published papers and books of mine. Where appropriate, I have modified the passages to suit the current context and composition without detailed citations and quotation marks so as to preserve continuity. Readers interested in the original sources should consult Lo (1997, 1999, 2002), Lo and MacKinlay (1999), and Lo and Repin (2002).

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mutation, reproduction, and natural selection--determine the efficiency of markets and the waxing and waning of financial institutions, investment products, and ultimately, institutional and individual fortunes. I conclude by considering some surprisingly sharp implications of the AMH for portfolio management, and by outlining an ambitious research agenda for formalizing several aspects of this rather unorthodox alternative to the classical EMH.

The Classical Efficient Markets Hypothesis

There is an old joke, widely told among economists, about an economist strolling down the street with a companion. They come upon a $100 bill lying on the ground, and as the companion reaches down to pick it up, the economist says, "Don't bother--if it were a genuine $100 bill, someone would have already picked it up". This humorous example of economic logic gone awry is a fairly accurate rendition of the EMH, one of the most hotly contested propositions in all the social sciences. It is disarmingly simple to state, has farreaching consequences for academic theories and business practice, and yet is surprisingly resilient to empirical proof or refutation. Even after several decades of research and literally thousands of studies, many published in this journal, economists have not yet reached a consensus about whether markets--particularly financial markets--are, in fact, efficient.

As with so many of the ideas of modern economics, the origins of the EMH can be traced back to Paul Samuelson (1965), whose contribution is neatly summarized by the title of his article: "Proof that Properly Anticipated Prices Fluctuate Randomly". In an informationally efficient market, price changes must be unforecastable if they are properly anticipated, i.e., if they fully incorporate the information and expectations of all market participants. Roberts (1967) and Fama (1970) operationalized this hypothesis--summarized in Fama's well-known epithet "prices fully reflect all available information"--by placing structure on various information sets available to market participants.

This concept of informational efficiency has a Zen-like, counterintuitive flavor to it: the more efficient the market, the more random the sequence of price changes generated by such a market, and the most efficient market of all is one in which price changes are completely random and unpredictable. This is not an accident of Nature, but is in fact the direct result of many active market participants attempting to profit from their information. Driven

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by profit opportunities, an army of investors pounce on even the smallest informational advantages at their disposal, and in doing so, they incorporate their information into market prices and quickly eliminate the profit opportunities that first motivated their trades. If this occurs instantaneously, which it must in an idealized world of "frictionless" markets and costless trading, then prices must always fully reflect all available information. Therefore, no profits can be garnered from information-based trading because such profits must have already been captured (recall the $100 bill on the ground). In mathematical terms, prices follow martingales.

A decade after Samuelson's (1965) landmark paper, many others extended his framework to allow for risk-averse investors, yielding a "neoclassical" version of the EMH where price changes, properly weighted by aggregate marginal utilities, must be unforecastable (see, for example, LeRoy, 1973; Rubinstein, 1976; and Lucas, 1978). In markets where, according to Lucas (1978), all investors have "rational expectations", prices do fully reflect all available information and marginal-utility-weighted prices follow martingales. The EMH has been extended in many other directions, including the incorporation of non-traded assets such as human capital, state-dependent preferences, heterogeneous investors, asymmetric information, and transactions costs. But the general thrust is the same: individual investors form expectations rationally, markets aggregate information efficiently, and equilibrium prices incorporate all available information.

More generally, the current EMH paradigm can be summarized in the "three P's of Total Investment Management" (see Lo, 1999): prices, probabilities, and preferences. The three P's have their origins in one of the most basic and central ideas of modern economics, the principle of supply and demand. This principle states that the price of any commodity and the quantity traded are determined by the intersection of supply and demand curves, where the demand curve represents the schedule of quantities desired by consumers at various prices and the supply curve represents the schedule of quantities producers are willing to supply at various prices. The intersection of these two curves determines an "equilibrium", a price-quantity pair that satisfies both consumers and producers simultaneously. Any other price-quantity pair may serve one group's interests, but not the other's.

Even in this simple description of a market, all the elements of modern finance are present. The demand curve is the aggregation of many individual consumers' desires, each derived

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